ESG Ratings for securitisation transactions cut out the background noise

Carmen Muñoz is Managing Director and Global Head of Resources at Sustainable Fitch, a global team of analysts and researchers specialised in assigning ESG ratings. Sustainable Fitch is an affiliate of Fitch Group. Carmen will join the panel discussion at the Securitisation Event entitled “ESG: what are the next steps?” She talks about the Sustainable Fitch approach to ESG Ratings.

What is the main difference between Fitch Ratings’ ESG-relevance scores and Sustainable Fitch’s ESG ratings?

Fitch Ratings factors in ESG considerations through ESG Relevance scores as part of their credit ratings, and Sustainable Fitch assigns ESG Ratings. (Sustainable Fitch is a Fitch Solutions company and while part of the Fitch Group is separate and independent from Fitch Ratings.)

What is the difference between these approaches?

At Fitch Group we approach ESG data and analysis from two different angles: Fitch Ratings analysts assigns ESG-relevance scores to indicate which ESG risks (be that an environmental, a social or a governance aspect) are material and relevant to a credit rating decision. By contrast, at Sustainable Fitch we assign ESG Ratings which focus on ESG impact and define the ESG quality of financial instruments and entities. These are among the first ESG analysis products to provide both a qualitative and quantitative ESG assessment of entity or transaction based on third-party principles and guidelines.

What can that mean in practice?

Fitch Ratings looks at the financial materiality of ESG aspects that are credit-related and speak to the probability of default (PD) of an instrument. In assigning ESG Ratings Sustainable Fitch is not focused on the PD of an instrument, rather on its ESG impact.

For example, mortgages to a borrower acquiring an A-rated energy efficient property may not necessarily have lower credit risk than another borrower who acquires an E-rated property. Therefore, for a structured finance transaction, this environmental aspect would be credit neutral. However, at Sustainable Fitch we would look at the same bond through a very different lens and by asking: “what are the framework’s targets in achieving carbon neutrality?” The ESG rating would reflect positively the focus of a particular transaction on energy efficient mortgages. This is significantly different approach.

What are the benefits of ESG Ratings for securitisation?

Our ESG Ratings are particularly interesting for investors who seek data on factors other than just returns. Parties which want to know how bonds will make a difference, in terms of Environmental, Social and Governance impact. Securitisations are highly targeted products. Our impact based ESG Ratings very much depend on the nature of the assets being securitised. For auto ABS, we would look carefully at the underlying vehicle engine types and whether there is a large electric vehicle component, for example. For mortgages we would be looking for loans which further the energy efficiency of a particular property and for commercial real estate we would factor in energy efficiency of the building.

Are there other benefits?

The beauty of ESG ratings for securitisation is that they take out weak aspects in the company’s ESG profile which affect unsecured debt. An example: Say you have an essentially “brown” organisation represented by an energy company — which wants to grow in renewables. In that example, you would see that the ESG rating for the entity would be in the lower end of the scale. However, the proposed bond framework whose use of proceeds includes improving energy sources towards renewables would then potentially allow for a much higher ESG rating for the framework than for the entity itself. For securitisations we only focus on the framework.

Have any recent securitisations attracted your attention due to their ESG significance?

There have been some interesting developments in the treatment of Electric Vehicle (EV) loans in China. The frameworks for many EV Auto ABS transactions follow a strict use-of-proceeds criteria in that 100% of proceeds must be used to finance consumer loans for EVs only. This is in addition to already having an asset pool which is already loans for the purchase of EVs. It is early days yet, however this example does illustrate how targeted securitisation is. Its structure may influence new Auto ABS, as more electric vehicles are being financed in the rest of the world. There remain some questions regarding the residual value of electric vehicles and the recycling of batteries, however.

What do you see in terms of trend regarding credit ratings which are linked to ESG topics?

In terms of impact on credit ratings, ESG has had a minimal impact so far. The reason for this is a lack of data to be able to prove whether or not the capacity of the borrower to pay back is better or less good if they have an energy efficient property, for example. Having said that, in the Dutch mortgage market we have seen concrete positive data points concerning the social aspect of ESG. We have been able to understand that the borrowers’ payment capacity is better when their mortgages are covered by the Dutch national mortgage guarantee NHG.

Have there been direct results due to these findings?

Yes, Fitch Ratings applies lower stresses for Dutch mortgages with an NHG guarantee which is reflected in its credit rating criteria and, hence, less credit enhancement for the structure. This looks at the loans through a social-related ESG lens, which could also reflect positively on ESG relevance scores.

How about Energy Performance Certificates on housing?

EPCs are very challenging because they are very heterogenous in Europe. The European Commission is in the process of revising the Energy Performance of Building Directive which will hopefully drive some convergence and enable more consistent data in the future. But this is a global challenge.

What is unique about the Fitch ESG rating method?

We are capable of informing the market from both a credit perspective and from an impact perspective. When users want to assess financial materiality of ESG they can read our credit reports. If they want the impact aspect they can refer to our ESG Rating reports. Sustainable Fitch is powered by human insight and has differentiated Fitch for over 100 years.

Is this approach gaining traction in the market?

ESG is becoming increasingly important in the market both from a regulatory perspective and from an investors point of view. Companies realise that to access the market for funds, they have to give greater visibility on their non-financial statements, and that includes ESG-related information.

Does this trend help in terms of ESG data, which you mentioned is scarce?

The good news is that financial statements currently attempt to collect as much sustainability and ESG data as possible but oftentimes data is not consistent across companies. There is a real need for more standardised definitions before we can really make some sense of certain things.

Are there other aspects of the Dutch market which you look at which illustrate the state of the market in your view?

The Dutch market is very interesting, certainly in that it provides quite extensive energy efficiency data for residential mortgages. From an Impact point of view that’s very positive as it makes bond frameworks more transparent.

Have you seen any developments in Europe regarding sustainable auto loan securitisations?

In Europe, there have not yet been any EV securitisations. But I would hope to see one soon.

Are there other developments in ESG-related securitisation we should look out for?

There seem to be different pockets of activity worldwide in terms of ESG-related securitisations, mainly asset driven. In the US we have seen solar panel loan securitisations, EV loans through Tesla, and Fanny Mae is involved in providing mortgages specifically for energy efficient residential properties within a green bond framework. China has established the aforementioned guidelines for green assets as reflected in consumer EV lending with strict use of proceeds conditions. So, there are currently interesting developments happening in different places.

What are you hoping to see yourself personally at the Amsterdam Securities Event?

It will be great to catch up on new developments in the Netherlands and other countries, and, in terms of ESG, more and more people seem to be speaking the same language, nowadays, which is encouraging!